Workshop on Transfer pricing

Workshop on Transfer pricing -WIRC of ICAI

-WIRC of ICAI

Comparable Uncontrolled Price Method (CUP) Resale Price Method (RPM)

Cost Plus method (CPM) CA Ramesh Iyer

31-10-2014

Comparable Uncontrolled Price

Method(CUP)

Slide No.

Resale Price Method (RPM)

Slide

No. Cost Price Method (CP)

Slide No.

What is CUP? 4 What is RPM? 19 What is CPM? 36

Controlled &

Uncontrolled transactions

5 Conditions for RPM 20 Costs 37

Internal & External CUP 6 - 7 Calculation of ALP 21 GP Margin 38 Comparability 8 Gross Profit Margin 22 Factors which affect

GP Margin

39

Comparability Factors 9-13 Factors that influence the Resale Price Margin

23-27 When can CPM be used?

40

Public Exchanges 14 Example 1 28 Relevant points to be

considered

41

Functional Analysis 15 Example 2 ^{29-32 Examples 42-46}

Adjustments 16 Relevant points to be

considered

33 Difficulty in using CPM 47

Comparable Uncontrolled Price Method (CUP)

Method (CUP)

What is CUP ?

•• CUP CUP (Comparable (Comparable Uncontrolled Uncontrolled Price) Price) is is the the most most direct direct method

method of of for for calculating calculating ALP(Arm’s ALP(Arm’s Length Length Price) Price)..

•• Under Under this this method method ::

–

– The The price price charged charged for for the the product/services product/services in in the the comparable

comparable uncontrolled uncontrolled transaction transaction is is determined determined..

–

– Such Such price price is is then then adjusted adjusted to to account account for for the the functional functional differences

differences between between the the international international transaction/Controlled

transaction/Controlled transaction transaction and and the the Comparable Comparable Uncontrolled

Uncontrolled Transaction Transaction which which would would materially materially affect affect the

the price price in in the the open open market market..

–

– The The adjusted adjusted price price is is taken taken as as the the Arm’s Arm’s Length Length Price(ALP) Price(ALP)..

What are Controlled and Uncontrolled Transactions?

I.

I. Controlled Controlled Transactions Transactions – – Transactions Transactions between between the the assessee assessee with with the the AE/s(Associated AE/s(Associated Enterprise/s)

Enterprise/s)

II.

II. Uncontrolled Uncontrolled Transactions Transactions – –

Transactions Transactions between between the the Assessee Assessee or or AEs AEs with with third third parties parties – – The The prices/value

prices/value of of goods/services goods/services in in these these transactions transactions are are Internal Internal CUP CUP..

Transactions Transactions between between unrelated unrelated parties parties – – The The value value of of the the goods/services goods/services in in

Transactions Transactions between between unrelated unrelated parties parties – – The The value value of of the the goods/services goods/services in in these

these transactions transactions are are External External CUP CUP..

Calculating Calculating ALP ALP on on the the basis basis of of public public data data also also comes comes under under External External CUP CUP..

While

While using using public public date date the the following following are are to to be be taken taken care care of of::

•• the the data data is is widely widely and and routinely routinely used used in in ordinary ordinary course course of of business business in

in the the industry industry to to negotiate negotiate prices prices for for uncontrolled uncontrolled sales/services sales/services

•• data data is is used used to to set set prices prices in in the the controlled controlled transaction transaction in in the the same same way

way that that it it is is used used by by uncontrolled uncontrolled taxpayers taxpayers in in the the industry industry;; and and

•• the the amount amount charged charged in in the the controlled controlled transaction transaction is is adjusted adjusted to to reflect

reflect product product and and service service variations variations..

CUP – Internal & external

Internal CUP

1 2

External CUP

1

Seller

(AE) Seller

Buyer

(AE) Seller

(AE)

Buyer (AE)

1 2

1- Controlled Price 2 – Uncontrolled Price

2

1- Controlled Price 2 – Uncontrolled Price Seller

(AE)

Buyer (AE)

Buyer

Seller Buyer

CUP – Internal & external

• Possibilities

– Same property & same circumstances

– Same property & similar circumstances

– Similar property & same circumstances

– Similar property & same circumstances

– Similar property & similar circumstances

Comparability

• Comparability if

– None of the differences

• between the transactions compared or

• between the enterprises undertaking those

• between the enterprises undertaking those transactions

materially affect the price in the open market or

– Reasonably accurate adjustments can be made to eliminate the material effects of those differences

[OECD TP Guidelines Para 2.14]

Comparability Factors

• similarity of product

– differences in the physical/functional features

• contract terms

– volumes, – discounts,

– interest free periods/terms of payment, – exchange rate exposure

– exchange rate exposure – after sales services

– warranty

• economic/market conditions

– geographic differences in the markets, – the particular time period of the contracts – the relative bargaining power of parties – strategies of buyers and sellers

• price competition

• marketing intangibles like brand names

Product similarity

• Product characteristics

– Qualitative – Functional – Origin

• OECD TP Guidelines para 2.18

• Product differentiation lead to additional cost

– Product development – Manufacturing

– Market research – Marketing

– Branding

Product similarity - Examples

Example 1

One enterprise sells unbranded Colombian coffee beans to its AE. The only available uncontrolled transaction involved unbranded Brazilian coffee beans.

• Product specification

– Difference in the coffee beans due to origin

– For example, whether the source of coffee beans commands a premium or requires a discount generally in the open market.

requires a discount generally in the open market.

Example 2

Manufacturer sells to OEMs unbranded printers and to its AE distributors same printers, though branded. As the Manufacturer reserves the right to supply consumables to his AE distributors, it sells branded printers at a discount.

• Product Specifications

– Branding - comparable generally internal

– After sales business - Whether quantifiable

Markets

• Markets vary in terms of

– Geography – Competition

– Customer structures – Time

– Time

• Markets can include multiple countries

– Active grey market between countries may imply a single market

• Markets may be segmented

– Customer preferences

– Psychological price barriers

Markets

Example

A cosmetic is sold at high price to overseas AE boutiques while the same cosmetic in different packaging is sold to large supermarkets in that country at lower price.

• Comparability

– Same product except for the packaging – Same market geographically

– Sales at retail levels – Same time

• Differentiation

– Different target customers – Different price segments

– Bargaining power of large supermarkets

Public exchanges

• Comparability with tested transactions

– Prices driven by equilibrium between supply and demand – homogenous nature of the product

– availability of pricing information to both buyers and sellers

• Imperfect CUPs due to

– Basic differences in terms and conditions of transactions – Basic differences in terms and conditions of transactions

– Complete lack of commitment of buyers and sellers other than the deal on the exchange

– Adjustments for differences with off market transactions reduce CUP reliability

• Buyer may lock in future purchases at fixed price because of its supply commitments at fixed price

• Seller may prefer stability of long-term contract to volatility (and risk) of selling through exchange.

• Buyer may need a different quality which differs from that of an Exchange

• Despite limitations, Public Exchange CUPs accepted widely by authorities.

Functional Analysis for CUP

• Not limited to identifying a price between unrelated parties

• A limited functional analysis of parties to focus on-

– Product/intangible/service characteristics – Contractual terms

– Contractual terms – Volumes

– Timing

– Level of markets operated by parties

– Long-term supply/purchase commitments – Buy back commitments

• Other factors that would affect the price

Adjustments

Sale to AE Sale Non-AE Remarks

Price

FOB CIF Freight & insurance Rs.

550

Quantity discount

yes No 1 CD of Rs. 10 each for

every CD writer every CD writer

Plus Rs. 20 per CD writer

Credit

One month Cash and carry Cost of credit 1.25%

Warranty

No warranty Six month warranty Cost of warranty Rs. 250

/unit

• Whose CUP- Buyer’s or seller’s?

• Could produce wide range of potential CUPs.

• Uncontrolled Price may range between best alternative price of seller before

shipping and buyer’s best price including shipping costs.

Concluding thoughts

• CUP most attractive if appropriate data is available

• CUP data-specific

– Standard for what constitutes appropriate data tends to rise with tax authorities experience

– Revenue can question whether every detail is exactly the same like differences in timing or other factors

– CUP method audits can become prolonged – CUP method audits can become prolonged

• CUP method to have sufficient coverage and adjustments for differences

• Prices derived from one or two ‘distress purchases’ or transactions outside their normal markets not CUP

• If potential CUP not used, an explanation why it is not used should be documented.

• Present other method (TNMM) as best method and offer CUP as a

fall back method

RESALE PRICE METHOD (RPM)

(RPM)

What is Resale Price Method?

• RPM is a method used to determine ALP(Arm’s Length Price) only when goods purchased from AE(Associated Enterprise) are resold to unrelated parties and there is very little value addition involved by the assesee.

Transfer Price Resale Price

Assessee/ Unrelated

• If the Transfer Price > than the ALP as worked out by this work-back method the difference is disallowed in the assessment.

• ALP in this method is calculated by working back from the resale price.

AE Assessee/

Reseller

Unrelated

party

Some other conditions under which RPM is the suitable method to calculate ALP

1. If an enterprise(Assessee)performs all the functions an independent distributor might be expected to perform.

2. If the reseller on-sells within a short time

3. Where the assessee is a trader, without value 3. Where the assessee is a trader, without value addition or physical alteration to the goods – Packing , repacking, labelling or minor assembly does not constitute physical alteration.

4. Reseller does not apply intangible assets to add

value.

Calculation of ALP under the RSM

Resale Price xxx

1. Less : Normal GP margin on same/similar property or service

in comparable uncontrolled Transaction xx 2. Less : Expenses in connection with purchase of

property/service xx

3. Add/Less : Adjustments for opening and closing stocks of 3. Add/Less : Adjustments for opening and closing stocks of

goods purchased from Aes xx

4. Add/Less : Functional/other differences between the

transactions/enterprises xx

ALP (Arm’s Length Price) xxx

1 - G P MARGIN / Resale Price Margin

• The resale price margin represents the amount out of which the reseller would seek to cover its selling and other operating expenses and, in the light of the functions performed (taking into account assets used and risks assumed), make an appropriate profit – OECD TP guidelines.

• Gross profit margin can be determined in any of the two methods –

1. First is the gross profit margin of the assessee itself.(Internal RPM) But when gross profit margin of the assessee itself is considered, then such gross profit margin has to be worked out excluding the purchases from the associated enterprises and sales thereof. When purchases from the associated enterprises and sales thereof. When the purchases from the AE are proportionately very high and excluding them will give a very negligible quantity of transactions the 2

method is used.

2. The gross profit margin taken from comparable uncontrolled transactions entered into by similarly placed concerns. (External RPM)

The first method takes precedence over the second when comparable

and appropriate internal GPM is available.

Important Factors that influence the Resale Price Margin

1. If the reseller RPM

performs limited services as a forwarding agent or broker

Comparable RPM can be derived from an examination of Commission or brokerage.

takes property in the goods, assumes the business risks, warehouses and distributes them to customers

the resale profit margin applicable to a principal would be relevant

distributes them to customers

also undertakes marketing, education and other activities, assumes warranty and other risks and employs intangible assets such as a developed distribution network. (in addition to the above)

the additional functions undertaken, risks assumed and intangibles used should result in higher returns

Has exclusive right to resell the goods The value to be attributed to such exclusive

right will depend to some extent upon its

geographical scope, substitute goods etc.

Important factors which influence the Resale Price Margin – contd .

2. Where the accounting practices differ from the controlled to

uncontrolled transactions

Appropriate adjustments should be made to the data used in calculating the Resale Price Margin.

3. Time of Resale A resale price margin is more 3. Time of Resale A resale price margin is more

accurate where it is realised within a short time of the reseller's purchase of the goods.

4. Value added by the Reseller/level of activities performed by the

Reseller

The Margin would be higher if the

value added is more and vice versa.

2 - Expenses in connection with purchase of property /service

• These expenses do not refer to the purchase

• These expenses do not refer to the purchase price but to expenses connected with

purchases - Freight , customs duty etc

3 - Opening and Closing Stock adjustments

• Resale in any financial year may be out of the opening stock.

• Goods may remain in closing stock.

• Just reducing GP margin and expenses without adjusting for opening stock and closing stock of

• Just reducing GP margin and expenses without adjusting for opening stock and closing stock of goods purchased from AEs will give only cost of sales and not the value of purchases.

• Therefore, closing stock of goods purchased from

AEs be added and opening stock of goods

purchased from AE be reduced.

4 - Functional/other differences between the transactions/ enterprises

• Some of the differences which may require adjustments are:

a) sales and purchases accounted for inclusive/exclusive of taxes

b) method of pricing - FOB/CIF b) method of pricing - FOB/CIF c) foreign exchange fluctuations.

d) Level of market(Wholesale, retail etc.)

e) Contractual Terms – Warranties, credit , sales volume.

f) AMP activities.

Example 1

10% Margin

@ Rs.3500 P

Parent Co.

C C Unrelated Distributor

S

Distributor for P (AE)

Customer

Customer

S performs promotional and marketing functions for P whereas C does not.

ALP : Resale Price Rs.3500

Less: Margin based on Company C’s transactions (10%) Rs. 350 Less: Adjustment for marketing costs Rs. 80

Transfer Price(ALP) Rs.3070

for P (AE)

for P (AE)

Example 2- ICAI Guidance Note

Controlled Transaction

@Rs.3800 pu @ Rs.4000 pu

Y Ltd – Foreign Company

holding 30% shares

in X Ltd

X Ltd – Indian Company

A Ltd – Unrelated

party

Comparable Uncontrolled Transaction

@ 20% margin

K Ltd. - Unrelated

Supplier

X Ltd – Indian Company

M Ltd – Unrelated

party

Example 2 Contd….

Nature of transactions - Resale by X Ltd ^.

To A Ltd. To M Ltd

Sales are Ex shop • Sales are FOR destination.

• The freight and transit insurance paid

• Gross profit margin being higher by 3%

• Sale price remained unchanged

• Freight and insurance is debited to Profit and Loss Account.

Quantity Discount given due to which GP Margin lower by 2%

• Gift of 3 Units of Product “P” for every Unit of Product “R”

• Cost debited to P&L so GP margin unaffected

• Extended warranty of 6 months of Rs.500 per unit.

• Costs charged to P&L so GP margin

Example 2 Contd….

Nature of transactions – Purchases of X Ltd.

From Y Ltd.(Controlled) From K Ltd(Uncontrolled) Freight Rs.10 per unit , Customs Duty

Rs.25 per unit. It is assumed that the freight charges will have a bearing on the gross profits

Only customs duty Rs.25 per unit

Quantity discount of Rs.10 per unit

• Extended Warranty for 6 months.

Warranty costs debited to P&L Offers Credit for 1 month – Cost of Credit

1.25 % per month .Interest cost debited

to P&L.

Example 2 -Calculation of ALP

• Calulation of Normal GP Margin : Comparable uncontrolled transaction is purchase from K Ltd. And sales to M Ltd whose GP Margin is 20%. This has to be adjusted suitably for differences between transactions with A Ltd.

GP Margin with M Ltd 20%

Less : Difference between Ex shop and FOR prices 3%

Less : Difference due to quantity discount 2%

Normal Profit with M Ltd. 15%

• Calculation of ALP

• Calculation of ALP

Price charged to A Ltd. Rs.4000

Less: Normal GP Margin @15% Rs. 600

Less: Expenses connected with purchase Rs. 35 (freight & customs duty paid)

Add: Freight incurred in case of purchase from Y Ltd. Rs. 10 Less : Quantity discount allowed by Y Ltd. Rs. 10

Arm's length price Rs. 3365

Adjustment = = Rs.435 per unit ie for 100 units Rs.43500

Rs.3800(Price paid to Y) less :Rs.3365

Relevant points to be considered before using RPM

• What potential comparables( including any uncontrolled purchases and resales of the tested party or its affiliates) are available to apply RPM and which if any should be selected?

• When there are differences between the potential comparables and the controlled reseller and what adjustments can be made to narrow the differences?

narrow the differences?

• Should all the activities of the controlled reseller be analysed as a single grouping or should the analysis be undertaken separately for various segments of the controlled reseller? Should several entities be combined for analysis?

• Are all the data and assumptions complete and accurate?

Difficulty in application of RPM

1. The Indian databases do not provide the data on gross margins and detecting the gross margin/sales realised by third parties proves usually difficult.

2. The RPM is unlikely to lead to accurate results if there are differences in level of market , functions performed and product.

3. In theory the RPM is requires an item-by-item analysis under which the 3. In theory the RPM is requires an item-by-item analysis under which the appropriate GP margin is determined for each item purchased by the reseller from the AE on the basis of its resale. In practise RPM is applied on a global basis.

4. Sometimes there will be a series of controlled sales.

5. In some cases multiyear data may be required to be used.

COST PLUS METHOD CP method

CP method

What is Cost Plus Method(CPM)?

• OECD guidelines explains CPM as follows:

o CPM begins with the costs incurred by the supplier of property (or services) in a controlled transaction for property transferred or services provided to an associated purchaser.

o An appropriate cost plus mark up is then added to this cost, to o An appropriate cost plus mark up is then added to this cost, to make an appropriate profit in light of the functions performed and the market conditions.

o What is arrived at after adding the cost plus mark up to the above costs may be regarded as an arm's length price of the original controlled transaction.

Arm’s Length Price(ALP) = Direct costs + Indirect costs + Adjusted GP margin

COSTS

• 'Cost' in cost plus means actual costs and not estimated costs.

• As the terms 'direct' or 'indirect' costs are not defined in the transfer pricing provisions, a reference may therefore be made to the industry practice as well as the pronouncements of the ICAI for an industry. Any deviation made by the enterprise as compared to the industry practice or the pronouncements of the ICAI will have to be justified.

or the pronouncements of the ICAI will have to be justified.

• In identifying and adopting the direct and indirect cost, the following

factors would also have to be borne in mind: (a) utilisation of the

plant; for example, if the plant has been under utilised the method of

absorbing fixed costs may have to be suitably adjusted; (b) method of

absorbing costs; absorption costing method is normally to be

preferred.

Gross Profit Margin/Mark up

• The comparable gross mark-up may be determined by reference to either:

(i) the cost plus mark-up that the same supplier earns in comparable independent party transactions (internal comparable), or

(ii) the cost plus mark-up that would have been earned in

(ii) the cost plus mark-up that would have been earned in comparable transactions by an independent parties (external comparable).

• The normal GP mark up should be adjusted for functional and

other differences between the international transaction and the

comparable or between the enterprises involved in both the

transactions. Adjustment is to be made only if such differences

would materially affect GP margin in open market.

Some significant factors which affect Gross Profit

• Significant differences in value of the products

• Difference in cost structures eg: age of plant and equipment

• Difference in business experience – phase of development that the entity

• Manufacturing Prduction and process engineering

• Procurement purchase and inventory control

• Testing functions phase of development that the entity

is in

• Differences in management efficiency

• Accounting Practices

• Complexity of manufacturing or assembly

• Selling, general and administrative expenses

• Foreign currency risk

• Contractual terms

When can CPM be used ?

This method is to be adopted only in cases of supply of property or services to an associated enterprise.

Generally this method is used where:

o some semi-finished goods are sold between related parties o in respect of joint facility agreements

o in respect of joint facility agreements

o long-term buy and supply arrangements of provisions of services

o the controlled transaction is the provision of services

Relevant points to be considered while using CPM

• This method is not to be applied when the enterprise procures property or services from an associated enterprise.

• Products, which are functionally comparable, are good enough for benchmarking under Cost Plus Method. There is no necessity to benchmark with such product, which is 100 per cent identical.

• FAR analysis is critical in identifying functionally similar comparable

• FAR analysis is critical in identifying functionally similar comparable transactions.

• The application of CPM has to be on transaction basis rather than on global basis

• Apply a comparable mark up to a comparable cost basis. For instance, if the supplier to which reference is made in applying the cost plus method in carrying out its activities employs leased business assets, the cost basis might not be comparable without adjustment if the supplier in the

controlled transaction owns its business assets.

Example 1

Producer M Inventor

&

Producer

S Domestic manufacturer

D Overseas

AE

• Company D provides all the know-how used in the manufacturing of the drug and undertakes to acquire a fixed output from S every month.

• Payment is to be made based on the costs incurred by S, along with a mark-up to reflect a profit element for S.

• Based on S’s financial statements, the cost incurred to

manufacture one unit of the drug is Rs.70.

Example 1 - Contd

25% mark up

E

Unrelated Manufacturer

Independent Principals

• Company E has been identified as a potential comparable company.

ALP :

Direct and indirect cost incurred by S Rs.70.00 Arm’s length mark up (25% x 70.00) Rs.17.50

Transfer Price(as per CPM) Rs.87.50

Example 2- ICAI Guidance Note

Billing Rs.200000,Cost 175000 A

Indian Co.

Develops software

B

Foreign Co with 30%

share holding in

A

GP of 50% on costs M Ltd.

Unrelated Party A

Indian Co.

Develops

software

Example 2

Analysis of Transactions

With B Ltd With M Ltd

Technology support of value Rs.17500 received from B(10% of cost)

No technology support received from M Ltd.

Discount offered to B Rs.8750(5% of cost) No discount offered

Value of Business and marketing risks assumed by B Rs.13125(7.5% of cost)

No

Credit given to B cost of which is estimated at Rs.2625(1.5% of cost)

No credit given to M Ltd.

Example 2

Calculation of ALP

Step 1.Calculation of GP Margin

• G P Margin of M Ltd. 50%

• Less: Tech Support from M Ltd (1) 10%

• Less: Discount given to B 5%

• Less: Marketing functions performed

by A for M Ltd 7.5%

• Add: Cost of credit given to B 1.5%

• Adjusted GP Margin 29%

• Adjusted GP Margin 29%

Step 2. Calculation of ALP

• Costs incurred Rs.175000

• GP on the costs (29%) Rs.50750

• Arm’s Length Price Rs.225750(A)

• Price charged to B Rs.200000(B)

• Income Increases by Rs.25750(A-B)

• In cases where there is a well-recognised Trade Mark the GP Margins may be significant as it will vary for each good produced.

• Not enough guidelines with regards to the inclusion of certain costs like depreciation , finance costs etc.

• Should costs related to third party service provider, which could

Issues in application of CPM

• Should costs related to third party service provider, which could otherwise be received by the service recipient directly , be included in the costs for calculating the mark up for the CPM?- Pass thru costs.

• Availability of information on costs of comparable uncontrolled

parties.

Comparison - RPM with CPM

RPM CPM

The resale price method starts from the final selling price and subtracts an

appropriate gross margin to arrive at a purchase price.

The cost plus method starts by computing the cost of providing the goods or services and adds an appropriate mark-up.

This method is used for purchases from AE and resale to unrelated parties. No substantial value added by purchasers or resellers.

CPM is used in respect of property

transferred or services provided to an AE.

Thank You

Information contained herein is of a general nature and is not intended to address

the circumstances of any particular individual or entity. Although we endeavour to

provide accurate and timely information, there can be no guarantee that such

information is accurate as of the date it is received or that it will Continue to be

accurate in the future. No one should act on such information without appropriate

professional advice after a thorough examination of the particular situation.